by Timothy Lloyd
2014 was a blockbuster year for the private equity market as buyout exits topped $450 billion, a 91% jump from 2013 and a new industry record. Additionally, PE “dry powder” funds, or the cash kept on reserve, reached a global record of $1.2 trillion. While investors chased the proverbial heat, Bain & Company said in their “Global Private Equity Report 2015” that the majority of this capital pursued the same top-quartile performers. Unfortunately, the capital deluge has no impact on the number of viable targets in the ecosystem. Compounded by accommodative credit policies around the world, and the comp precedents set by frothy public markets, this investor oversubscription mainly serves to inflate target prices. As a result, 2015 poses some unique challenges for the private equity industry.
Caplinked has carefully studied the market and assembled a guide to 5 of the most compelling private equity trends of 2015. We are confident our ideas can help general partners and limited partners navigate these uncertain waters with actionable intelligence and disruptive strategies.
Expounding on the liquidity theme that launched the market’s recovery from the 2008 crisis, this capital typhoon creates a new set of problems for PE investors. With a limited amount of attractive targets, historically low interest rates and an overabundance of dry-powder capital, asset prices inevitably rise. This phenomenon exerts pressure on GPs to deviate from core values like, price discipline and prudence, as they must outbid competitors in a frenzied auction for desirable portfolio additions.
In an era of globally decelerating GDP growth, enlarged PE capital commitments almost guarantee longer holding periods to satisfy the industry standard, equity-appreciation multiple of 2. Generally, if PE investors haven’t, at minimum, doubled the value of their equity, an exit becomes unjustifiable. Macro conditions ensure that the “quick flip” asset holding period of 3 years, which has become fashionable in PE, will become a practice of the past. Bain projects that 5-year holding periods will reclaim their spot as the new normal.
• Never overpay for a target unless the strategic ROI of eliminating a competitive threat outweighs the cost of acquisition
• Longer holding periods mean PE investors most evaluate ROI prospects along a protracted time horizon
Africa’s Value Proposition
While endemic corruption, disease outbreaks and ethnic conflicts pose valid concerns for investors, some of the brightest minds in private equity are placing big bets on Africa. The Carlyle Group, for example, has a $698 million fund solely focused on the African continent, according to The Economist. In November of 2014, Carlyle announced that it was taking a 100% stake in South African tire manufacturer Tiger Automotive in a joint venture with Old Mutual Private Equity. Also, in January of this year, Helios Partners, a London-based firm, said it had raised a billion-dollar Africa fund.
PE investors are attracted to the continent’s growing consumer demand, its natural resource abundance, its need for infrastructure development (roughly $90 billion a year says the World Bank) and the deregulation of key industries. Despite the dearth of $100-million-acquisition opportunities, which larger firms prefer, investors like, Emerging Capital Partners’ Co-CEO Hurley Doddy says “there are not many $100m deals for sale, but plenty of $100m opportunities to bolt together.”
Keys for Success
• Have boots on the ground and cultivate strong ties with local influencers and officials
• Embrace longer holding periods in a nascent frontier market
Healthcare’s Organizational Disruption
According to KPMG’s “2015 M&A Outlook Survey Report,” 84% of 735 M&A professionals surveyed said that healthcare will be the most active M&A sector in 2015. Destabilized by recent Obamacare legislation, the healthcare industry faces dramatic restructuring demands, which call for significant private equity investment and engineering. Other factors that will drive PE capital into the space include consolidation of core businesses and the need for consumer growth.
Within the healthcare vertical, the most attractive subsectors include: hospitals, managed care, diagnostics and pharmaceuticals. Also, according to Bain & Company, conditions for healthcare exits remain strong due to robust public equity markets and “hungry strategic buyers.”
Keys for Success
• Regulatory risk remains high – IE; Republican power shift could reverse Obamacare laws
• Anticipate magnified competition for assets and steep target valuations
The Rise of Shadow Capital
The phenomenon of institutions and pension funds passively investing alongside PE funds is nothing new. But, Bain & Company argues that this trend has been scaling aggressively as PE allocations within institutional AUM pies’ have grown from a weighted average of 6% in 2012 to 12% today. It seems that institutions are seeking a level of private equity participation that exceeds the boundaries of traditional PE fund investing.
While there are benefits to co-investing alongside institutions, this so-called shadow capital injects more liquidity into a market that is already oversubscribed. The institutions that were once limited partners and clients have now emerged as disruptive threats capable of bypassing general partner structures and diminishing margins for PE firms.
• Elite PE firms will continue to outperform, capturing the AUM and returns they deserve
• Underperforming PE entities will become extinct
• Institutions will learn to value the expertise of proven PE leaders
First-Time Funds Capture Assets as Top-Quartile Persistence Wanes
Although the majority of investment capital is chasing the same small group of outperforming funds, the data indicates that only 20 percent of the best managers have two top-quartile funds in a row, according to Forbes. Additionally, 30 percent of these managers achieve this performance only once in their firms’ lifecycles. These sobering facts mean that track record is longer a suitable metric to evaluate future performance.
Based on this information, the optimist might say there has never been a better inflection point to launch a private equity fund. The American economy is healthy, energy is still relatively cheap, manufacturing costs are down and disruptive new industries are challenging the regulatory foundations of America. As for the latter, more intrepid PE entrepreneurs might want to examine Privateer Holdings’ business model.
• If you’re a small fish in a big pond, pick a spot where the big fish won’t eat you
• Superior data and information asymmetry can level the playing field
• High-risk, high-reward
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